Two Secrets About U.S. Finances

Two Secrets About U.S. Finances
You Won't Read Anywhere Else

Most people misunderstand two things about the U.S. financial situation...

First, the U.S. government's official debt burden might not yet have reached the "red line" of imminent default. But our entire economy's enormous debt burden makes it nearly certain we will default on our federal debt and many of our private debts, too.

The U.S. is the world's largest debtor. As a whole, Americans owe a total of nearly $56 trillion dollars (almost 400% of GDP). That's federal, state, municipal, corporate, and private (mortgages and student loans) debts. The debt service on our total obligation is $3.6 trillion a year. It's hard to put that number into context because it's so large. Think about it this way – It's roughly the same amount of money as the federal government's entire budget.

To the extent our debts fueled past consumption (homes, cars, credit cards, health care, etc.), they are unlikely to spur future economic growth. That's not to mention a considerable portion of these payments belongs to foreign investors, folks who are typically more interested in building their next factory in Bangladesh than in Bangor.

When you combine this "debt tax" – aka interest – with the size of our actual tax burden (about $4.4 trillion when you combine federal taxes with state and local taxes), you can see pretty clearly why our economy is struggling.

We're spending half our annual GDP on taxes and interest.

Imagine if you had to spend half of your family's income on taxes and interest. How would you rate your credit risk? What's the likelihood of default in that scenario?

More important, given our current federal deficits and the looming entitlement crisis we face (total unfunded future liabilities in excess of $100 trillion)... How is it possible to expect Americans will be able to afford to pay more taxes? What would happen to our budget if interest rates rise because of inflation, which seems inevitable?

We don't think many Americans – even sophisticated investors – have considered these numbers. Our foreign creditors will realize they have no chance of being repaid in sound money. Americans simply cannot afford debt service, never mind principal repayment. There are signs they already recognize this...

Mainstream economists have long scoffed at the possibility that our foreign creditors might stop funding our existing debts at an interest rate we can afford. When you pose the question about our poor credit, they tell you our trading partners can do nothing about the dollar. If they want to sell goods to Americans, they have to accept our dollars. As Nixon's Treasury Secretary John Connally said, "It's our dollar, but it's their problem."

For years, that was true. But it's changing. Increasingly, U.S. trading partners are taking our dollars, but instead of recycling them back into Treasury bonds, they're buying gold and strategic commodities, like oil and copper and steel. That's why prices for these commodities have soared. That's obvious to most folks. What isn't so obvious is what it means for the bond market...

For the last nine months, the Federal Reserve has been purchasing 70% of all the debt issued by the U.S. Treasury. What happens when the Fed stops buying? With 70% less demand for Treasurys, we expect prices to fall. Benchmark interest rates will rise. Bill Gross agrees, which is why he's shorting Treasurys. Higher benchmark interest rates – perhaps sharply higher should cause the U.S. dollar to strengthen against foreign currencies (like the Euro) and against commodities. It should also cause most U.S. stocks to fall.